Capital Gains Tax Exemptions You Should Know About

When you sell an asset for more than you paid for it, the resulting profit is a capital gain that may be subject to tax. A capital asset is property you own for personal use or as an investment, such as a house, stocks, or bonds. The amount of tax you owe often depends on how long you held the asset before selling it.

A short-term capital gain comes from selling an asset you have owned for one year or less and is taxed at your ordinary income tax rate. A long-term capital gain results from selling an asset held for more than one year and usually qualifies for lower tax rates. Fortunately, tax law provides several exemptions that can legally reduce or eliminate the tax owed on these gains.

Primary Residence Sale Exemption

The most widely used capital gains exemption pertains to the sale of a primary residence. Single individuals can exclude up to $250,000 of the gain, while married couples filing a joint return can exclude up to $500,000.

To qualify, homeowners must satisfy two tests. The Ownership Test requires you to have owned the home for at least two of the five years leading up to the sale. The Use Test mandates that you have lived in the home as your primary residence for at least two of the five years before the sale. The two years for each test do not have to be continuous or simultaneous.

For example, if a single filer bought a home for $300,000 and sold it five years later for $600,000, the capital gain is $300,000. Assuming you meet the requirements, you could exclude $250,000 of that gain, meaning you would only owe tax on the remaining $50,000. If you were married and filing jointly, the entire $300,000 gain would be excluded from tax.

If a spouse dies, the surviving spouse may be able to claim the full $500,000 exclusion if they sell the home within two years of the death, provided the couple met the ownership and use tests beforehand. In cases of divorce, each ex-spouse can exclude up to $250,000 of gain from their share of the home, as long as each person meets the eligibility tests.

A partial exclusion may be available if the sale is due to a change in employment, specific health reasons, or other unforeseen circumstances recognized by the IRS. For instance, you may qualify for a prorated exclusion if a new job is at least 50 miles farther from your home than your old job was. Members of the uniformed services, Foreign Service, or intelligence community on qualified official extended duty can also elect to suspend the five-year test period for up to 10 years.

Investment-Related Exclusions

Beyond real estate, several provisions allow investors to reduce or eliminate capital gains taxes on specific types of financial investments.

One exclusion involves Qualified Small Business Stock (QSBS). This rule allows investors to exclude 100% of the capital gains from the sale of stock in certain small businesses. To qualify, the stock must have been acquired at its original issuance from a domestic C corporation with gross assets not exceeding $50 million. The investor must also hold the stock for more than five years.

The Opportunity Zone program provides tax benefits to investors who reinvest capital gains into Qualified Opportunity Funds (QOFs). These funds invest in economically distressed communities designated as Opportunity Zones. By rolling over a recent capital gain into a QOF, an investor can defer paying tax on that gain until the end of 2026. If the investment is held for at least 10 years, the investor may be able to eliminate capital gains tax on any appreciation of the QOF investment itself.

Donating long-term appreciated assets directly to a qualified charity is another strategy. When you donate an asset like stock that you have held for more than one year, you can generally take a charitable deduction for the fair market value of the asset. You also avoid paying the capital gains tax that would have been due had you sold the asset first and then donated the cash.

Strategies for Deferring or Reducing Gains

While not direct exemptions, several tax planning strategies can defer or reduce the amount of capital gains tax owed.

When an individual inherits a capital asset, such as real estate or stocks, the asset’s cost basis is adjusted to its fair market value at the date of the original owner’s death. This “step-up in basis” revaluation erases the capital gain that accumulated during the decedent’s lifetime. For example, if your parent bought stock for $10,000 and it was worth $100,000 on the day they passed away, your new basis becomes $100,000, and an immediate sale would result in no capital gain.

Gifting an appreciated asset is another strategy. When you gift an asset, you do not realize a capital gain, but the recipient takes on your original cost basis in a “carryover basis.” If the recipient later sells the asset, they will be responsible for paying the tax on all the appreciation since you first acquired it. The annual gift tax exclusion limits the value of gifts you can give to any one person per year without potential tax consequences.

Tax-loss harvesting involves selling investments at a loss to offset capital gains from other investments. Capital losses first offset gains of the same type (short-term vs. long-term), and any excess losses can then offset the other type of gain. Should you have more losses than gains, you can deduct up to $3,000 of the excess loss against your ordinary income each year, with any remaining loss carried forward. The “wash-sale rule” prevents you from claiming a loss if you buy a substantially identical security within 30 days before or after the sale.

Reporting Exemptions and Gains on Your Tax Return

Accurately reporting transactions to the IRS is a necessary step to claim any exemption or properly calculate the tax due. The primary forms for this are IRS Form 8949, Sales and Other Dispositions of Capital Assets, and Schedule D, Capital Gains and Losses.

For most capital asset sales, you will start with Form 8949. This form is where you list the details of each transaction, including the description of the property, acquisition and sale dates, sales price, and your cost basis. The form is divided into parts for short-term and long-term transactions, so you must report each sale in the correct section.

To claim the primary home sale exclusion, you report the sale on Form 8949. In the column for adjustments, you will enter a specific code (Code H) and the amount of the gain you are excluding. This adjustment reduces the taxable gain shown on the form.

Schedule D consolidates the information from all your Form 8949s and calculates your total net capital gain or loss for the year. The final figures from Schedule D are then carried over to your main tax return, Form 1040.